1 of 37 chapter: 23 >> Krugman/Wells ©2009  Worth Publishers Tracking the Macroeconomy

2 of 37 WHAT YOU WILL LEARN IN THIS CHAPTER  How economists use aggregate measures to track the performance of the economy.  What gross domestic product, or GDP, is and the three ways of calculating it.  The difference between real GDP and nominal GDP and why real GDP is the appropriate measure of real economic activity.  What a price index is and how it is used to calculate the inflation rate.

3 of 37 The National Accounts  Almost all countries calculate a set of numbers known as the national income and product accounts.  The national income and product accounts, or national accounts, keep track of the flows of money between different parts of the economy.

4 of 37 The National Accounts  Households earn income via the factor markets from wages, interest on bonds, dividends on stocks, and rent on land.  A stock is a share in the ownership of a company held by a shareholder.  A bond is borrowing in the form of an IOU that pays interest.  In addition, households receive government transfers from the government.  Disposable income, total household income minus taxes, is available to spend on consumption or to save.

5 of 37 The National Accounts  Private savings, equal to disposable income minus consumer spending, is disposable income that is not spent on consumption.  The banking, stock, and bond markets, which channel private savings and foreign lending into investment spending, government borrowing, and foreign borrowing, are known as the financial markets.

6 of 37 The National Accounts  Government purchases of goods and services (G) is paid for by tax receipts as well as by government borrowing.  Exports (X) generate an inflow of funds into the country from the rest of the world, while imports (IM) lead to an outflow of funds to the rest of the world.

7 of 37 The National Accounts  Inventories are stocks of goods and raw materials held to facilitate business operations.  Investment spending is spending on productive physical capital, such as machinery and construction of structures, and on changes to inventories.  Final goods and services are goods and services sold to the final, or end, user.  Intermediate goods and services are goods and services—bought from one firm by another firm— that are inputs for production of final goods and services.

8 of 37 Aggregate Spending  Aggregate spending, the sum of consumer spending, investment spending government purchases of goods an services, and exports minus imports, the total spending on domestically produce final goods and services in the economy.  CIG(X-M) or CIGX Where X = Net Exports (Exports-Imports)

9 of 37 Gross Domestic Product  Gross domestic product or GDP measures the total value of all final goods and services produced in the economy during a given year.  total value : In current year prices.  final goods and services: Intermediate goods do not count.  in the economy: Within the physical boundaries of a nation.  given year: Only G&S produced in that year count.

10 of 37 PITFALLS GDP: What’s In and What’s Out Included  domestically produced final goods and services (including capital goods)  new construction of structures  changes to inventories Not Included  intermediate goods and services  inputs  used goods  financial assets like stocks and bonds  foreign-produced goods and services

11 of 37 GDP… “… does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our courage, nor our wisdom, nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud that we are Americans.” - Senator Robert Kennedy, 1968

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15 of 37 Calculating Gross Domestic Product  GDP can be calculated three ways:  Add up the value added of all producers  Add up all spending on domestically-produced final goods and services. This results in the equation: GDP = C + I + G + (X – IM)  Add up all income paid to factors of production

16 of 37 Calculating Gross Domestic Product

17 of 37 Calculating Gross Domestic Product $15,000 10,000 5, ,000 Value added by government = 11.5% Value added by households = 11.5% Value added by business = 77.1% Consumer spending = 70.3% Investment spending = 15.4% Government purchases of goods and services = 19.4% Components of GDP (billions of dollars) C + I + G = $14,515 Net exports X – IM = –$708 (– 5.1%) Spending on domestically produced final goods and services Value added by sector

18 of 37 Real vs. Nominal GDP  There are two possible reasons for total spending to rise from one year to the next:  The economy may be producing a larger output of goods and services.  Goods and services could be selling at higher prices.

19 of 37 Real vs. Nominal GDP  Nominal GDP is the value of all final goods and services produced in the economy during a given year, calculated using the prices current in the year in which the output is produced.  Real GDP is the total value of the final goods and services produced in the economy during a given year, calculated using the prices of a selected base year.  B/c prices are constant, real GDP reflects the change in goods and services produced. It is the best measure of aggregate production.

20 of 37 Real vs. Nominal GDP  Except in the base year, real GDP is not the same as nominal GDP, output valued at current prices.  GDP per capita is a measure of average GDP per person, but is not by itself an appropriate policy goal.

21 of 37 Real vs. Nominal GDP DO IT! Calculating Nominal GDP and Real GDP Year 1Year 2 Quantity of apples (billions)2,0002,200 Price of apple$0.25$0.30 Quantity of oranges (billions)1,0001,200 Price of orange$0.50$0.70 Nominal GDP (billions of dollars) Real GDP (billions of year 1 dollars)

22 of 37 The GDP Deflator  The GDP deflator is a measure of the overall level of prices.  Definition: One way to measure the economy’s inflation rate is to compute the percentage increase in the GDP deflator from one year to the next. We will do this in Chapter 24…Something to look forward to!!!! GDP deflator = 100 x nominal GDP real GDP

23 of 37 EXAMPLE: Compute the GDP deflator in each year: year Nominal GDP Real GDP GDP Deflator 2002$ $8250$ $10,800$ :100 x (6000/6000) = :100 x (8250/7200) = :100 x (10,800/8400) = % 12.2%

24 of 37 Consumer Price Index  Consumer price index (CPI) – a measure of the overall cost of the goods and services bought by a typical consumer.  How the CPI is Calculated: Fix the number of goods in the basket. Find their prices. Compute the baskets cost. Choose a base year and compute the index.

25 of 37 Inflation Rate, CPI, and other Indexes  The inflation rate is the yearly percentage change in a price index, typically based upon Consumer Price Index, or CPI, the most common measure of the aggregate price level.  The consumer price index, or CPI, measures the cost of the market basket of a typical urban American family.

26 of 37  CPI - Fix the basket: 3 footballs and 4 basketballs  Find the Price:  Cost of Basket:  Compute Index (year 1 is base)  Compute Inflation Rate: YEAR1 Football ($)1 Bball ($) 1$10$12 2 $15 3$14$18

27 of 37 GDP DEFLATOR -  Calculate Nominal GDP’s  Calculate Real GDP’s (Year 1 is Base)  Calculate GDP Deflator YEARPrice Football Quantity Footballs Price Bball Quantity Bballs 1$10120$ $12200$ $14180$18275

28 of 37 The GDP Deflator vs. the CPI  GDP deflator reflects the price of all goods produced domestically, while CPI reflects the price of all goods bought by consumers.  Since GDP takes all domestic goods and services into account, it automatically takes changes in these goods and services into account. CPI must do so manually by adjusting the basket (300 employees doing this)

29 of 37 Consumer Price Index

30 of 37 Other Price Measures  A similar index to CPI for goods purchased by firms is the producer price index.  Economists also use the GDP deflator, which measures the price level by calculating the ratio of nominal to real GDP.  The GDP deflator for a given year is 100 times the ratio of nominal GDP to real GDP in that year.

31 of 37 The CPI, the PPI, and the GDP Deflator Percent change in CPI, PPI, GDP deflator 25% Year

32 of 37 The End of Chapter 23 coming attraction: Chapter 24: Unemployment and Inflation